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Summary

  • Not all stock drops are the same.
  • It is never wise to sell a valuable asset for less than it’s worth just because others are fearful.
  • Emotions should never be allowed to contaminate investor behavior.

Introduction

When it comes to forecasts about the stock market, there is certainly no shortage of alarmists. This is not only true within the financial press; it seems to permeate the media at all levels. The very words "market crash" seem to have a Pavlovian effect on investors. However, instead of salivating, investors are often driven to shudder in fear. This is quite often especially true for retired investors living off of portfolios that they have spent a lifetime amassing. The possibility of losing a significant portion of assets that took a lifetime to accumulate would simply be too devastating to endure.

Moreover, it is one thing to be frightened, and quite another thing if you act upon those fears. Reacting to a situation, real or imagined, when you're scared can lead to disastrous and permanent consequences. This is especially insidious when you react to fears that are unjustified. One way to combat permanent damage is to understand the difference between realized losses and unrealized losses. I will be writing more about this later in the article.

In my opinion and long experience, most dire stock market forecasts are akin to "Chicken Little" episodes, where after an acorn falls upon its head, the little chicken runs around warning all that will listen that the sky is falling. Thankfully, Armageddon-type disasters rarely, if ever, come about.

On the other hand, it cannot be denied that "market crashes" of some level are sure to come along from time to time. Fortunately, they do not happen as often as many are afraid they will, and are usually less severe than our fears might lead us to believe. But even more importantly, I think it's imperative that investors always remember that precisely forecasting an actual and true market crash is quite unpredictable. In other words, attempting to forecast the near-term direction of the stock market is an exercise in futility, as most of the greatest investors that ever lived recognize and acknowledge.

But putting forecasting a market crash aside for a moment, the more important question is what should the intelligent investor do if and when one does occur? It may surprise some to learn that there are no simple or precise answers to this question. The only rational answer is that it depends. Even more practically speaking, a market crash implies falling stock prices. Therefore, the more practical question is what do I do if the prices of any of my stocks fall? Once again, the answer is, it depends.

To understand my point more clearly, the investor has to first realize that not all stock drops are the same. Sometimes a falling stock price should be sold, sometimes it should be held and at other times it should be bought. Moreover, the correct course of action is not always easy to discern. However, I contend that it should never be made based on a biased view of the market in the general sense. Instead, I believe the buy, sell or hold decision is best made one company at a time. As I stated many times before, stocks, like people, are unique entities. Consequently, I do not think they should be analyzed or all painted with the same broad brush.

There are important reasons why I feel so strongly about this. Although I will acknowledge that the majority of all stocks might drop in a true market crash, it does not necessarily follow that all drops in stock price should be viewed the same or dealt with in the same way. The truth boils down to the fundamental underlying health and strength of the individual businesses behind the stocks. Moreover, these same factors will be the primary determinants of whether a stock price drop is of a permanent or of a more temporary nature.

Frankly, a more permanent drop would truly be something to fear and/or be concerned about. However, a temporary drop might actually represent an incredible buying opportunity. However, it is hard to see opportunity when one is blinded by fear. Therefore, the simple moral to the story is that the rational and intelligent investor should always strive to keep their emotions in check in favor of making learned and well-reasoned investing decisions.

Consequently, what follows next will be a discussion attempting to highlight some of the more common and obvious types of stock price drops. More importantly, I will simultaneously attempt to provide some guidance on how to coherently determine what actions the prudent investor would be best served to take. Moreover, the reader should recognize that there are no perfect, pat or simple answers to these important questions. On the other hand, there are well-reasoned and rational strategies that can, and in my opinion, should be undertaken and applied.

Overvaluation Drop

One of the most, but not the most, devastating types of stock price drops result when a given company's stock price falls as a consequence of significant overvaluation. The reason that this type of falling price is so devastating relates to the potentially long and unacceptable time to recovery. To illustrate how devastating a fall from overvaluation can be, I will utilize a 20-year (which includes 2 forecast years) earnings and price-correlated F.A.S.T. Graphs™ on Home Depot, Inc. (NYSE:HD)

The orange line on the graph represents what I call the earnings-justified valuation line. The black line represents monthly closing stock prices since 1996. A careful observation illustrates that Home Depot's stock price began disconnecting from its earnings-justified valuation in 1997, before peaking at the end of 1999. Admittedly, this is an extreme example, but one that I believe clearly illustrates the dangers of overvaluation. At the end of 1999, Home Depot's P/E ratio exceeded 70.

To put this into context, new investors were paying more than $70 to purchase $1.00 worth of the company's current earnings. Stated another way, investors were paying 70 years in advance for Home Depot's current earnings. Clearly, this should have been a red flag to anyone cognizant of what the fair value of this stock should be. This is in spite of the fact that the company's 6-year historical earnings growth rate at that time was approximately 27% per annum. This calculates to a PEG ratio exceeding 2.5. I consider that both obvious and significant overvaluation.

However, the important lesson to be gleaned here is that it has taken approximately 13 years for Home Depot's stock price to return to those lofty heights of 1999 (the red line on the graph). Clearly, this is an unacceptable amount of time for an investor to merely get back to even. But perhaps even more devastating was the reality that Home Depot's stock price fell by almost 2/3rd, from approximately $70.00/share at its peak in 2000 to approximately a $23.00/share low in 2002.

Home Depot, Inc

(click to enlarge)

To me, the best strategy to protect the rational investor from the dangers of overvaluation is to recognize it when it occurs. There are many ways to do this, certainly tools such as F.A.S.T. Graphs™, the Value Line Investment Survey, MorningStar and others can be of great assistance. Of course, having a simple working knowledge of fair valuation is also quite useful.

To me, the key to dealing with overvaluation lies in the recognition that it is often an obvious mistake that can and should be avoided, especially when it is extreme. This does not mean that it can be avoided with perfect execution; Wall Street does not ring a bell at market tops. However, I strongly contend that selling an overvalued position either in total, or simply paring it back over time is a sound and valid approach. As the old Wall Street adage so eloquently puts it: sometimes bears win, sometimes bulls win, but the pigs get slaughtered.

In my way of thinking, the bottom line when dealing with overvaluation is that it should be sold. I believe that overvaluation will inevitably create a devastating stock price drop that can and should be avoided. Personally, my own strategy is that I will flag the company for potential sell once I believe that its price is two years or more ahead of its earnings-justified valuation. Other investors might implement their own strategies or approaches. However, I think it is imperative that investors be aware of the relative valuation of their stocks, and prepare a rational strategy for dealing with this risk effectively. Some might wait until the price begins to fall; others might start selling even though price continues to rise. Again, hitting perfect tops should not be the objective, protecting assets and/or harvesting excess profits seem like better goals to me.

Fundamentals Deteriorate Drop

Perhaps the most dangerous and potentially devastating price drop is the one that simultaneously concurs with the fundamentals of the business deteriorating. The venerable Marty Whitman, chairman of the board, Third Avenue Value Fund, eloquently and succinctly put this in perspective with the following tidbit of sage advice:

"Unrealized Market Depreciation occurs when the market price of a publicly traded security declines. Permanent impairment of Capital occurs when the Fundamental values of a business are dissipated with the consequent long-term adverse consequences."

We only need look back to the financial crisis that instigated the Great Recession of 2008 to find examples illustrating the effects of deteriorating fundamentals. The following earnings and price-correlated graph on Citigroup, Inc. (NYSE:C) clearly reveals the permanent, or near-permanent damage that deteriorating fundamentals can cause. When both price and earnings collapse, the damage can be long-lasting, as evidenced below.

Citigroup Inc.

(click to enlarge)

On the other hand, what makes the issue of deteriorating fundamentals even more dastardly is the challenge of making a distinction between a true long-term impairment of capital versus a temporary interruption in a company's business. Once again, I turn to Marty Whitman to shed some light on this nuance:

"If a permanent impairment of capital seems likely - sell. If there is to be unrealized market depreciation average down."

The following earnings and price-correlated graph on Wells Fargo & Company (NYSE:WFC), another well-known financial giant, illustrates the challenge referred to above. As we saw in the Citigroup example, the earnings of this financial powerhouse collapsed by approximately 75%, and stock price followed. Admittedly, this is a far cry from the losses seen on Citigroup, because Wells Fargo did remain profitable, although at a much lower level than it achieved in the previous years.

Moreover, in both cases, we also saw a significant dividend cut. The dividend cut was severe in the Citigroup example, and although to a lesser extent with Wells Fargo, the dividend cut was nevertheless unacceptable. However, what makes this difficult is the fact that Wells Fargo has generated a remarkable recovery on all levels. Earnings have recovered to record levels, the dividend is close to being restored and stock price is bouncing off of record highs.

Wells Fargo & Co.

(click to enlarge)

I believe there are only two practical strategies to protect investors from the devastation that fundamental deterioration can cause. First and foremost is to continuously monitor the businesses behind your stocks through continued and comprehensive research efforts. There are many tools available to help investors in this regard, including the ones mentioned above and others, but there is no research tool available that offers a 100% ironclad guarantee of protection.

However, the good news is that fundamental deterioration rarely manifests out of the clear blue. However, investors should be aware that on rare occasions, it can surprise even the most diligent investor. On the other hand, continuous monitoring and due diligence can often uncover potential issues before the devastation is too great. But as I previously stated, there are no guarantees.

The second tactical strategy is to engage in rational and appropriate diversification. To be clear, I am addressing this defensive strategy specifically to diversification within this one asset class known as equities or stocks. To be even clearer, broad diversification across numerous asset classes could also be useful and defensive. However, I am simply limiting the scope of this dissertation on common stock investing.

In other words, never put all of your stock eggs into one sector basket. Moreover, I tend to recommend eschewing a significant overweight to one sector, even if you're intrigued by the growth prospects of the industry. To be honest, I learned this lesson, as I have learned many of my best investing lessons, the hard way. Beginning in the mid-1990s, I was finding it difficult to find attractive valuations for my growth-oriented portfolios. However, there was one sector (the financial sector) that appeared reasonably valued, offered decent dividend yields and seemed like a relatively safe place to park cash.

Therefore, as I was coming out of many obviously and excessively overvalued tech stocks (ORCL, CSCO, EMC, etc.), I saw the financial sector as a safe haven to temporarily park cash. Consequently, I inadvertently created an overweight in the sector that I thought was safe (financials), but later learned that it wasn't. Fortunately, my overweight of this sector also simultaneously led to a broader diversification within that sector.

Nevertheless, I suffered extensive losses in well-known and highly regarded financials, such as AIG (NYSE:AIG), Citigroup and others. Fortunately, not all of the financials I was invested in collapsed, and I was able to come out of some of them with a healthy profit that mitigated some of the loss. However, lose some money I did, but the valuable lessons I gained fortunately proved to be more valuable in the long run.

The bottom line up to this point in this article is that there are certain potentially devastating types of stock price drops that should be sold. Holding on to what amounts to a permanent, or near-permanent impairment of your capital is not wise, and will rarely result in profits. The old Wall Street adage that your first loss is your best loss aptly applies under the circumstances I have cited thus far. On the other hand, there are times where selling is a bad idea, and other times when investing more (averaging down on your positions) is the best idea.

Strong Fundamentals Event-Instigated Price Drops

Thus far, I have focused on the types of price drops that should be sold. However, from this point forward, I will turn my focus to a few of the types of price drops that I believe should be held or bought. There are a couple of important reasons why I take this position. First and foremost, as I stated many times before, I never consider it wise to sell a valuable asset for less than its true worth, especially just because other fearful people may be doing it.

This is why I am such a fervent advocate of investors focusing first and foremost on fundamentals. Stock prices in an auction market can temporarily lie, and thus be misleading indicators of a company's real value. Consequently, I further advocate not just focusing on price second, but more importantly, only focusing on price as an indicator of fair valuation. This concept was the inspiration for my recent article titled "Stocks Are Two-Faced, And One Is A Pathological Liar".

The second important reason why I take this position relates to the concept of realized versus unrealized losses that I briefly referenced earlier. Simply stated, a realized loss is one that is generated by an outright sell. In contrast, an unrealized loss is simply a loss on paper that has yet to be actualized because the position remains intact and unsold.

The difference between these two types of losses is far more relevant and important than merely definitional. The realized loss becomes a permanent loss, especially if it leads to inaction resulting from being frozen by fear. Personally, it breaks my heart to know that many investors suffered these permanent losses as a result of the Great Recession of 2008. From firsthand experience coupled with hearing tales of many unfortunate souls that sold out at the bottom of that horrific market environment, my heart goes out to them.

Consequently, as I embark on the twilight of my career, it has inspired me to accept it as my personal mission to help others see the world of common stock investing more clearly. I am not arrogant enough to believe that everything I offer will always be true and correct advice. However, I will always strive to do so, based not only on the lessons I have personally learned, but also based on the lessons from studying and analyzing the teachings of those investors greater than me that have been both willing and generous with the sharing of their vast knowledge.

With the above said, allow me to share some of the positive, and alas some of the negative personal experiences I had through working with clients during the Great Recession of 2008. On the negative side, there was a major change emerging within my client base at the time. Many of my long-standing clients had matured into their retirement years, and therefore, were more focused on, and frankly more worried, about their financial futures than ever before.

Unfortunately, no matter how hard I tried to get them to focus off of falling stock prices and onto the strong and healthy fundamentals underpinning the businesses they owned, for some, it was to no avail. Even though the dividend-paying blue-chip stocks they were invested in were continuing to show strong profitability and were raising their dividends, these poor souls could not handle the stress and sold out. But even worse, these frightened investors stayed out of stocks, thereby permanently realizing what I felt were unnecessary losses.

Fortunately, I was able to convince the vast majority of my long-standing clients to stay the course, based on my ability to point out the quality and strength that the businesses they owned were continuing to possess. Although I am personally thankful, my gratitude is dwarfed by the thankful sentiments these valued clients with the courage to stay the course express to me today.

But here is the part I am most proud of. Even though we did suffer permanent losses on a few of our portfolio holdings, as I shared above, the vast majority of our holdings have recovered to record prices. But most importantly, in the aggregate, not one of those persistent clients suffered with a cut in their dividend income. Instead, each and every one received a raise in pay each year because the combined dividend increases of the successful blue chips overcame the losses created by the few losers. The lesson we all learned, don't sell perfectly strong and fine companies for less than their fundamental strengths indicate.

Portfolio of Champions

I offer the following 10 examples of great and well-known Dividend Champions to illustrate and summarize the reality of not selling a great business with strong fundamentals just because the stock price has temporarily dropped. I believe there are several real-world examples here that support the points I've attempted to make in this article. A careful study of each of the earnings and price-correlated graphs below, with dividends, should help the reader put the reality of market crashes and recessions into a clearer perspective.

As you review each of the graphs, put special focus on the orange earnings line and note how strongly these blue chips performed on an operating basis during the Great Recession of 2008. Some of these great companies displayed minor earnings weakness, but many performed as if the recession never occurred. Moreover, each of these great companies raised their dividend each and every year (the blue shaded area and the pink line on the graphs).

When reviewing their stock price action (the black line on the graph), there are several aspects that should be recognized. With some of the examples, you will see the effects of overvaluation, when the price is above earnings. You also will see that even during the recession, the price drop was more bark than bite. But perhaps most importantly, notice how truly temporary price drops were. The media had everyone scared to death, but when looked at from the longer perspective below, we must conclude that the fears were greatly overblown.

Imagine the cost to those unfortunate investors that realized those losses, in spite of the fact that the businesses they owned remained healthy and strong. I believe the evidence is clear, that had they been able to keep their wits about them and focus on fundamentals first, those losses should never have been taken. Unfortunately, it is very difficult for people to remain calm when they fear that their life savings might dissipate and disappear.

Johnson & Johnson (NYSE:JNJ)

(click to enlarge)

VF Corporation (NYSE:VFC)

(click to enlarge)

Kimberly-Clark Corporation (NYSE:KMB)

(click to enlarge)

Colgate-Palmolive Co. (NYSE:CL)

(click to enlarge)

The Coca-Cola Company (NYSE:KO)

(click to enlarge)

Wal-Mart Stores Inc. (NYSE:WMT)

(click to enlarge)

3M Company (NYSE:MMM)

(click to enlarge)

McDonald's Corp. (NYSE:MCD)

(click to enlarge)

The Clorox Co. (NYSE:CLX)

(click to enlarge)

Summary and Conclusions

In this part one of this two-part series, I highlighted the important principle that not all stock price drops are the same. There can be many reasons why the price of a common stock might fall, and sometimes the reasons are valid and justified, but sometimes they are not. Making those distinctions are critical factors that can determine whether an investor will achieve success or failure with their common stock portfolios.

Moreover, recognizing the true nature of a stock price drop should be the major factor determining the best action that the investor should take. Sometimes a price drop warrants an outright sell, sometimes it presents a great buying opportunity, and sometimes it should just be ignored and the stock held. Each individual investor's own unique situation also plays a part in making the best decision. However, I believe that regardless of the investor's situation, the decision should always be made with reason and upon a calm and thorough analysis of the underlying facts. Emotions should never be allowed to contaminate investor behavior, at least in my opinion.

Finally, much of what was written in this part one focused on dividend growth stocks and the dividend growth investor. In part two, my focus will move to the capital gain-oriented, or total return investor. Although the underlying principles presented here equally apply to investors focused on growth as they do to those focused on dividend income, there are subtle but important differences in what might be considered the most rational behavior or action to take.

Disclosure: Long C, WFC, JNJ, KMB, CL, CLX at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: I am long C, WFC, JNJ, KMB, CL, CLX, MCD, KO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: What Do I Do With My Stocks If The Market Crashes? Part 1